A home equity loan, also known as a second mortgage, is a loan that lets you convert your home equity into cash. A home equity loan is taken out on top of your original mortgage. For instance, if you took out a $200,000 mortgage and have already paid $100,000 on that loan, that means you own $100,000 worth of equity in your home. Now, if you decide to take out a home equity loan on some amount of the owned equity, say $50,000, you can receive that as a lump sum and use it to payoff other expenses.
The catch with a home-equity loan is that you will face a higher interest rate than that of your original mortgage. It will also likely be a fixed rate. Second mortgages can only be paid off after you’ve completed paying on the original, that is unless your second mortgage is with a different lender.
Home Equity Line of Credit
Another kind of home equity loan is a home equity line of credit (HELOC). This gives you the option to borrow up to an approved credit limit. With a HELOC you will only pay interest if you use the credit. It works very similarly to a credit card, in that when you make a withdrawal you will have a balance and an interest to payoff, except that your house is used as collateral.
Both home-equity loans and HELOCs are generally tax-deductible for amounts higher than $100,000, and your home remains an asset for you and your heirs. However, there is still the risk of foreclosure if you default on the loan. Plus, to take out either one of these loans you must hold at least 20% equity in the home.
When Should You Take One Out?
Second mortgages are typically used to quickly payoff large expenses, such as credit card debt, car payments, or college tuition. The interest rate is typically better than most offered on credit cards. Retirees looking for some extra cash to make it through their retirement may also consider taking out a home-equity loan. This is a more appealing option than say, a reverse mortgage, for seniors who need cash but don’t want to risk losing their home as part of their estate.
To see how a home-equity loan stacks up against a reverse mortgage, check out our “What Is a Reverse Mortgage?” post.